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How can an interest rate rule reflect real economic considerations?

Author

Listed:
  • Balázs Krusper

    (Magyar Nemzeti Bank (central bank of Hungary))

  • Katalin Szilágyi

    (Magyar Nemzeti Bank (central bank of Hungary), OG Research)

Abstract

Since March 2011 the projections published by the Magyar Nemzeti Bank have been prepared using the Monetary Policy Model (MPM), in which interest rates are determined endogenously as a function of macroeconomic variables. This paper explains the characteristics of the interest rate rule of the model. First, the interest rate rule assures that monetary policy stabilises inflation over the appropriate horizon (generally approximately eight quarters), that is, it achieves medium-term price stability. Second, it takes into account the considerations of the real economy (both directly and indirectly), that is, it does not make excessive real economic sacrifices to achieve its primary objective. We demonstrate through simulations in the MPM model that monetary policy can attach more weight to real economy considerations if it broadens its horizon, that is, if it becomes forward-looking. This means that if monetary policy looks through short-term surges in inflation, then in the event of an adverse cost-push shock it need not aggravate the slowdown of the real economy to combat inflation. Moreover, this forward-looking rule which neutralises only second-round effects provides for more favourable trade-off between the objectives of inflation and the stability of the real economy than a direct increase in the weight of real economy consideration in the interest rate rule.

Suggested Citation

  • Balázs Krusper & Katalin Szilágyi, 2013. "How can an interest rate rule reflect real economic considerations?," MNB Bulletin (discontinued), Magyar Nemzeti Bank (Central Bank of Hungary), vol. 8(2), pages 43-50, May.
  • Handle: RePEc:mnb:bullet:v:8:y:2013:i:2:p:43-50
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    File URL: http://www.mnb.hu/letoltes/krusper-szilagyi.pdf
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    References listed on IDEAS

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    1. Warne, Anders & Coenen, Günter & Christoffel, Kai, 2008. "The new area-wide model of the euro area: a micro-founded open-economy model for forecasting and policy analysis," Working Paper Series 944, European Central Bank.
    2. Michel Juillard & Charles Freedman & Dmitry Korshunov & Mr. Douglas Laxton & Mr. Ondrej Kamenik & Ioan Carabenciov & Igor Ermolaev & Jared Laxton, 2008. "A Small Quarterly Multi-Country Projection Model with Financial-Real Linkages and Oil Prices," IMF Working Papers 2008/280, International Monetary Fund.
    3. Ratto, Marco & Roeger, Werner & Veld, Jan in 't, 2009. "QUEST III: An estimated open-economy DSGE model of the euro area with fiscal and monetary policy," Economic Modelling, Elsevier, vol. 26(1), pages 222-233, January.
    4. Stephen Murchison & Andrew Rennison, 2006. "ToTEM: The Bank of Canada's New Quarterly Projection Model," Technical Reports 97, Bank of Canada.
    5. Dániel Felcser, 2013. "How should the central bank react to the VAT increase?," MNB Bulletin (discontinued), Magyar Nemzeti Bank (Central Bank of Hungary), vol. 8(1), pages 35-41, January.
    6. Jared Laxton & Igor Ermolaev & Charles Freedman & Mr. Ondrej Kamenik & Michel Juillard & Mr. Douglas Laxton & Ioan Carabenciov & Dmitry Korshunov, 2008. "A Small Quarterly Multi-Country Projection Model," IMF Working Papers 2008/279, International Monetary Fund.
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    Cited by:

    1. István Ábel & Orsolya Csortos & Kristóf Lehmann & Annamária Madarász & Zoltán Szalai, 2014. "Inflation targeting in the light of lessons from the financial crisis," Financial and Economic Review, Magyar Nemzeti Bank (Central Bank of Hungary), vol. 13(4), pages 35-56.

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    More about this item

    Keywords

    monetary policy; interest rate rules.;

    JEL classification:

    • E27 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E59 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Other

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